Tuesday, 2 April 2013

How Universal Credit and tax allowances will conflict

The introduction of the government’s flagship welfare reform, Universal Credit, introduces a major new challenge for any politician hoping to help struggling households with tax cuts. The design of Universal Credit means that, unlike under today’s tax credit system, cuts in taxes for low to middle income working families will be counteracted by reductions in a household’s Universal Credit entitlement. Put simply, under UC, tax cuts will not, in large part, reach low to middle income working households.

The reason can be summed up as follows. When someone’s taxes are cut – whether through an allowance increase or a 10p tax rate – this increases their post-tax income. However, in calculating the amount of Universal Credit a household receives, the government provides 65 pence less UC for each pound the family’s income increases after tax. This 65 per cent figure is known as the UC ‘taper’. Consequently, having cut taxes with one hand, it takes away nearly two thirds of the gain with the other.

Specifically, a tax allowance hike of £1000 would be expected to lead to a gain of £200 in post-tax income. However, this increase in post-tax income leads to a reduction of £130 in Universal Credit, and therefore a net gain of just £70. This means that rather than every taxpayer gaining a flat rate £200, those in the greatest need gain barely a third this amount – while those higher up, and not in receipt of Universal Credit, gain the full amount. With a tax cut achieved through a 10% tax band, the effect on Universal Credit is the same. Nearly two thirds of any benefit would be lost for those in UC.

This interaction between taxes and in-work benefits does not apply to large parts of the existing welfare system. While Council Tax Benefit and Housing Benefit are already assessed on the basis of net income, tax credits are assessed on the basis of pre-tax income, meaning that a tax cut has no effect on the amount of tax credit support received. The result is that, once UC is up and running (it is being phased in from later this year), tax cuts, already a relatively inefficient way of supporting low to middle income households, will become almost exclusively a policy for helping households on middle and higher incomes. For some time, as UC is rolled out gradually, those who happen to be on the new system will receive a far smaller gain from tax cuts than those remaining on the existing system.